Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that sinotrans limited (HKG:598) has a debt on its balance sheet. But does this debt worry shareholders?

What risk does debt carry?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.

Check out our latest analysis for Sinotrans

What is Sinotrans’ debt?

The graph below, which you can click on for more details, shows that Sinotrans had 13.2 billion yen in debt as of September 2021; about the same as the previous year. However, it has 12.8 billion national yen of cash to offset this, resulting in a net debt of approximately 394.2 million national yen.

A look at the responsibilities of Sinotrans

We can see from the most recent balance sheet that Sinotrans had liabilities of 24.8 billion yen coming due within one year, and liabilities of 15.2 billion yen due beyond that. In return, he had 12.8 billion Canadian yen in cash and 18.8 billion domestic yen in debt due within 12 months. It therefore has liabilities totaling 8.31 billion Canadian yen more than its cash and short-term receivables, combined.

While that might sound like a lot, it’s not that bad since Sinotrans has a market capitalization of 29.8 billion Canadian yen and so it could likely bolster its balance sheet by raising capital if needed. But it is clear that it must be carefully examined whether he can manage his debt without dilution. Carrying practically no net debt, Sinotrans has indeed a very light debt.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.

Sinotrans has a low debt to EBITDA ratio of only 0.10. And remarkably, although she has net debt, she has actually received more interest in the last twelve months than she has had to pay. So there’s no doubt that this company can go into debt and still be cool as a cucumber. Another good sign, Sinotrans was able to increase its EBIT by 24% in twelve months, thus facilitating the repayment of its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Sinotrans can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

But our last consideration is also important, because a company cannot pay off its debts with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Sinotrans has recorded free cash flow of 84% of its EBIT, which is higher than what we usually expect. This puts him in a very strong position to repay his debt.

Our point of view

The good news is that Sinotrans’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. Given this set of factors, it seems to us that Sinotrans is quite cautious with its debt, and the risks seem well controlled. The balance sheet therefore seems rather healthy to us. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. Know that Sinotrans shows 1 warning sign in our investment analysis you should know…

If you are interested in investing in businesses that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.